sense and nonsense in modern corporate finance

Thought # 1: A lot what youve been taught is wrong (in my view)

Example # 1: The Notion of Risk in Academic Corporate Finance

William Sharpe, Noble Laureate

High degree of variability means high risk

Low degree of variability means low risk

Inference: Treasury bonds are risk-free securities because they have zero variability of return.

Treasury bonds are risk free Hmmm

We define risk, using dictionary terms, as the possibility of loss or injury.

The real risk that an investor must assess is whether his aggregate aftertax receipts from an investment (including those he receives on sale) will over his prospective holding period, give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake.

If you forego ten hamburgers to purchase an investment;

receive dividends which, after tax, buy two hamburgers;

and receive, upon sale of your holdings, after-tax proceeds that will buy eight hamburgers,

then you have had no real income from your investment, no matter how much it appreciated in dollars.

You may feel richer,

but you wont eat richer.

Investing in Treasury bonds is the SUREST way to lose money in the long run
If you think of risk as probability of permanent loss of capital. I know of no other logical common sensical way of thinking about risk. We will return to Buffetts thoughts on risk in a while.

Example # 2: The Relationship between Risk and Return in Academic Corporate Finance

Academic Finances Definition of Risk

Two components: Systematic and Unsystematic risk

Investors will not get paid to assume unsystematic risk because that component of total risk can be diversied away.

Investors will get paid only for taking systematic risk, a proxy of which is beta.

Academics...like to dene investment risk differently, averring that it is the relative volatility of a stock or portfolio of stocks - that is, their volatility as compared to that of a large universe of stocks.

High Risk High Return

Low Risk Low Return

Stocks with high beta are riskier than stocks with lower betas but are expected to deliver higher returns. Hmmmmm

Stocks with high beta are riskier than stocks with lower betas but are expected to deliver higher returns.

Do ?

Do stocks with large betas outperform stocks with low betas? Ans: No

Do

Do stocks with identical beta produce same returns? Ans: No

Is

a proxy for

Ans: No Volatility is not the same as risk.

Beta does not capture risk

How does He think of Risk?

Though this risk cannot be calculated with engineering precision, it can in some cases be judged with a degree of accuracy that is useful The primary factors bearing upon this evaluation are:

A. The certainty with which the long-term economic characteristic s of the business can be evaluated

B. The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows

C. The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself.

D. The purchase price of the business

E. The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor's purchasingpower return is reduced from his gross return.

The Trouble with his definition of risk? You cannot objectively measure it!

Is that a problem?

False precision is totally crazy... It only happens to people with high IQs.

The desire to be PRECISE makes people do some incredibly FOOLISH things.

Its better to be approximately right than to be precisely wrong - John Maynard keynes

The desire to be PRECISE makes people do some incredibly FOOLISH things.

Not everything that counts can be counted, and not everything that can be counted, counts. Einstein

HOW DOES HE THINK ABOUT THE RELATIONSHIP BETWEEN RISK AND RETURN

If someone were to say to me, I have here a sixshooter and I have slipped one cartridge into itWhy dont you just spin it and pull it once? If you survive, I will give you $1 million.

I would decline perhaps stating that $1 million is not enough.

Then he might offer me $5 million to pull the trigger twice... Now that would be a positive correlation between risk and reward!

The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, its riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case.

This is one of those ideas that grab you immediately, or you struggle with it all your life. For me it grabbed me immediately when I encountered it in Buffetts essay, The Superinvestors of Graham-and-Doddsville while studying in London.

The greater the potential for reward in the value portfolio, the less risk there is.

Return

Risk

TO MAKE MONEY TAKE RISK

TO MAKE MONEY SHUN RISK

Tweedy Browne

One of the many unique and advantageous aspects of value investing is that the larger the discount from intrinsic value, the greater the margin of safety and the greater potential return when the stock price moves back to intrinsic value... Contrary to the view of modern portfolio theorists that increased returns can only be achieved by taking greater levels of risk, value investing is predicated on the notion that increased returns are associated with a greater margin of safety, i.e. lower risk.

I have never been able to figure out why its riskier to buy $400 million worth of properties for $40 million than $80 million.
The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy. Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people who think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to gure out why its riskier to buy $400 million worth of properties for $40 million than $80 million. And, as a matter of fact, if you buy a group of such securities and you know anything at all about business valuation, there is essentially no risk in buying ten $40 million piles for $8 million each. In assessing risk, a beta purist will disdain examining what a company produces, what its competitors are doing, or how much borrowed money the business employs. He may even prefer not to know the company's name. What he treasures is the price history of its stock. In contrast, we'll happily forgo knowing the price history and instead will seek whatever information will further our understanding of the company's business. After we buy a stock, consequently, we would not be disturbed if markets closed for a year or two.

Example # 3: The Capital Asset Pricing Model (CAPM)

Employing databases and statistical skills, these academics compute with precision the "beta" of a stock - its relative volatility in the past - and then build arcane investment and capital-allocation theories around this calculation.

In their hunger for a single statistic to measure risk, however, they forget a fundamental principle: It is better to be approximately right than precisely wrong.

His rst critique of CAPM is that it uses beta, which is a awed measure of risk. But there is a second, terribly important critique of CAPM.

To understand that, we need to jump over a jurisdictional boundary of corporate nance into the realm of psychology.

Jumping over jurisdictional boundaries: An introduction to multidisciplinary thinking.

envy

Envy is the only one of the seven deadly sins which gives us nothing. There is NO upside in envy. Rejecting opportunities that would make you rich because others have better ones is envy. You will never nd the mention of envy in any corporate nance textbook. Does that mean you should ignore its inuence on human decisions simply because the idea belong to another discipline?

How crazy it would be to be made miserable by the fact that someone else is doing better because someone else is always going to be doing better at any human activity you can name. - Charlie Munger
What the hell do I care if somebody else makes money faster. Theres always going to be somebody who is making money faster, running the mile faster or what have you. Once you get something that works ne in your life, the idea of caring terribly that somebody else is making money faster strikes me as insane. If youve got a way of investing your money that is overwhelmingly likely to keep you comfortably rich and someone else nds something that would make him richer faster, that is not a big tragedy. So, Buffett and Munger

Reject projects where IRR<WACC

Dont be envious

Lets digress a bit here because I want to talk to you a bit more about multidisciplinary thinking. We will return to discussion of envy in corporate nance in a while. Here is a story in corporate nance illustrating one of the best decisions made by Warren Buffett in his career.

CEO Textile Company Commodity Yarn Global Commodity Business Extremely Competitive

A textile machinery manufacturer approaches you with a proposal to sell you a new type of textile machine, which is more efficient than any machine invented till date.

Cost of machinery: Rs 10 cr. Expected life of machine: 10 years Annual savings: Rs 2.50 cr. p.a.

Expected residual value of the machine: Rs 1 cr. Cost of capital: 15% p.a.

Accept or reject?

How did Buffett solve this problem?

How did Buffett solve this problem?

WTF?

By jumping over jurisdictional boundaries of multiple disciplines

The domestic textile industry operates in a commodity business, competing in a world market in which substantial excess capacity exists. Much of the trouble we experienced was attributable, both directly and indirectly, to competition from foreign countries whose workers are paid a small fraction of the U.S. minimum wage. Over the years we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs... Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benets than would have resulted from comparable expenditures in our highly-protable candy and newspaper businesses. But the promised benets from these textile investments were illusory.Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide. Viewed individually, each companys capital investment decision appeared cost-effective and rational.Viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic. Thus, we faced a miserable choice: huge capital investment would have helped to keep our textile business alive, but would have left us with terrible returns on ever-growing amounts of capital. After the investment, moreover, the foreign competition would still have retained a major, continuing advantage in labor costs. A refusal to invest, however, would make us increasingly non-competitive, even measured against domestic textile manufacturers.

[Buffett] knew that the huge productivity increases that would come from a better machine introduced into the production of a commodity product would all go to the benet of the buyers of the textiles. Nothing was going to [come to us] as owners. Thats such an obvious concept that there are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business thats still going to be lousy. The money still wont come to you. All of the advantages from great improvements are going to ow through to the customers. Conversely, if you own the only newspaper in town and they were to invent more efcient ways of composing the whole newspaper, then when you got rid of the old technology and got new, fancy computers and so forth, all of the savings would come right through to the bottom line. In all cases, the people who sell the machinery and, by and large, even the internal bureaucrats urging you to buy the equipment show you projections with the amount youll save at current prices with the new technology. However, they dont do the second step of the analysis which is to determine how much is going to stay home and how much is just going to ow through to the customer. Ive never seen a single projection incorporating that second step in my life. And I see them all the time. Rather, they always read: This capital outlay will save you so much money that it will pay for itself in three years. So you keep buying things that will pay for themselves in three years. And after twenty years of doing it, somehow youve earned a return of only about four percent per annum. Thats the textile business. And it isnt that the machines werent better. Its just that the savings didnt go to you. The cost reductions came through all right. But the benet of the cost reductions didnt go to the guy who bought the equipment. Its such a simple idea. Its so basic. And yet its so often forgotten.

Which jurisdictional boundaries did Buffett jump over?

Competition [Microeconomics] Prisoners Dilemma [Game Theory] Return on Capital [Accounting] Opportunity Cost [Microeconomics] Slow Contrast Effect [Psychology] Commitment & Consistency [Psychology]

Mental Models

A mental model is a representation inside your head of an external reality

You observe something and then you try to relate to it a model inside your head.

If all you have is one tool, you will tend to overuse it.

All the wisdom in the world is not to be found in one little academic department. A disastrous way to think and operate.

Youve got to have models in your head...

To think much better, youll need a checklist of mental models Why?

Because the human mind is like the human egg. It jumps to conclusions: First conclusion bias

As soon as a sperm enters the egg, theres an automatic shut-off device that bars other sperms from getting in.

Economics Psychology Accounting Neurology Physics

Mathematics Probability Engineering Evolutionary Biology

About 20 models from psychology constitute behavioral nance

Mental models will come from multiple disciplines

Youve got to array your experience both vicarious and direct on this latticework of models...

Students who just try to remember and pound back what is remembered, well, they fail in school and fail in life. Youve got to hang experience on a latticework of models in your head.

Mental Model Example

Quote: lets all play carefully guys so that we can all win a little!

Overpriced
A stock buyback at a bargain price

Value Investing (to an extent)

FUNCTIONAL EQUIVALENTS

Financial Derivatives

of Zero Sum Game

Positive feedback: Negative feedback: Nuclear Chain Bathroom Gyeser reaction

Negative feedback loops: from physiology- Body temperature, blood clotting, digestive system- SELF CORRECTING Positive Feedback loops Are there functional equivalents of negative feedback loops?

Business Cycles- Negative Feedback

Business cycles - booms follow busts follow booms - Feedback loop, power of incentives (psychology), envy (psychology), overoptimism (psychology), prisoners dilemma (game theory), Tobins Q (microeconomics).

Bank Runs

Low prices and high volumes feed on each other Dominant newspaper (Circulation and advertising feed on each other)

Coin ipping example Mean as an attractor Regression to the Mean [Statistics]

Stock prices and Stock returns Bull markets and Bear markets can obscure mathematical laws, but they cannot repeal them. Buffett

In the short run the market is a voting machine, but in the long run its a weighing machine. - Ben Graham

Many shall be restored that are now fallen and many shall fall that are now in honor - Horace

Physics envy

Lets return to the subject of envy

B schools aspire to the same standards of academic excellence that hard disciplines embracean approach sometimes waggishly referred to as physics envy.- Warren Bennis

Virtually none of todays top-ranked business schools would hire, let alone promote, a tenure-track professor whose primary qualication is managing an assembly plant, no matter how distinguished his or her performance. Nor would they hire professors who write articles only for practitioner reviews, like this one. Instead, the best B schools aspire to the same standards of academic excellence that hard disciplines embracean approach sometimes waggishly referred to as physics envy. Business school professors using the scientic approach often begin with data that they use to test a hypothesis by applying such tools as regression analysis. Instead of entering the world of business, professors set up simulations (hypothetical portfolios of R&D projects, for instance) to see how people might behave in what amounts to a laboratory experiment. In some instances those methods are useful, necessary, and enlightening. But because they are at arms length from actual practice, they often fail to reect the way business works in real life. When applied to businessessentially a human activity in which judgments are made with messy, incomplete, and incoherent data statistical and methodological wizardry can blind rather than illuminate. http://en.wikipedia.org/wiki/Warren_Bennis http://www.rasalevickaite.lt/kmtm/skaitinys.pdf

In physics it takes three laws to explain 99% of the data; in finance it takes more than 99 laws to explain about 3%.Andrew Lo

Watch this video: Warning: Physics Envy May be Hazardous to Your Wealth http://mitworld.mit.edu/video/794/

Imagine how much harder physics would be if electrons had feelings! Richard Feynman

Why are economists trained so formally? It makes sense to axiomatize a discipline when the axioms are true (or almost so) and have strong predictive power. Thats the case for euclidean geometry, for example, as well as Maxwells electromagnetic theory, where many valid, useful, and accurate predictions follow from applying the laws of deduction to a few initial assumptions. But economists seem to have embraced formality and physics envy without the corresponding benets of accuracy or predictability. In physics, Maxwells theory and quantum mechanics allow you to predict the way an electron spins about its own axis inside a hydrogen atom to an accuracy of twelve decimal places. Something that accurate isnt just a modelits a law. In economics, by contrast, there are no laws at all, only models, and youre immensely lucky if you can predict up from down... Clearly, then, when someone shows you an economic or nancial model that involves mathematics, you should understand that, despite the condent appearance of the equations, what lies beneath is a substrate of great simplication andsometimes great and wonderful imagination. Thats not a bad thingnancial markets are all about imagination. But you should never forget that even the best nancial model can never be truly valid because, unlike the physical world, the mental world of securities and economics is much less amenable to the power of mathematics. http://www.ederman.com/new/docs/beware.hbr.pdf

in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusionsBen Graham
There is a special paradox in the relationship between mathematics and investment attitudes on common stocks, which is this: Mathematics is ordinarily considered as producing precise and dependable results; but in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw therefrom. In 44 years of Wall Street experience and study I have never seen dependable calculations made about common-stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra. Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment.- Ben Graham

Economics should emulate physics basic ethos, but its search for precision in physics-like formulas is almost always wrong.

Learn to focus on avoidance of foolish behavior

Lets return to the examples of how youve been mis-taught (in my view).

Example # 4: Markets are Efcient

If investors did get an extra return (a risk premium) for bearing unsystematic risk... ...it would turn out that diversied portfolios made up of stocks with large amounts of unsystematic risk would give larger returns than equally risky portfolios of stocks with less unsystematic risk... Investors would snap up the chance to have these higher returns, bidding up the prices of stocks with large unsystematic risks and selling stocks with equivalent betas but lower unsystematic risk... This process would continue until the prospective returns of stocks with the same betas were equalized and no risk premium could be obtained for bearing unsystematic risk.. Any other result would be inconsistent with the existence of an efficient market. [taken from Sharpes book, Investments] In other words, assume a theory [EMT] is true, then make another theory [CAPM] based on that. Then say, hey, if something happens that disproves CAPM, that must mean EMT is not true, but because we KNOW its true, then CAPM must also be true!

There are no undervalued or overvalued securities and that market prices are always correct. Price= Value

EMT: Stock prices reect everything about a companys prospects and the state of the economy.

Implication: Investors who seem to beat the market year after year are just lucky

No point doing any type of analysis Price already reflects all possible analysis

Supporting Argument: Prices change quickly in response to new information. But do price change correctly?

or Do markets tend to overreact? Do they Under-react

Yes. This has been empirically tested several times. Stock market is a semi-psychotic creature given to extremes of elation and despair.

Supporting Argument: Most investors cant beat the market

But how could most investors do better than the market when they are the market?

If superior performance was caused due to luck, would not that performance revert to the mean over time?

EMT proponents insist that its not worth looking at the track record of Buffett, Munger, Walter Schloss, Tweedy Browne, and other super-investors

The proposition that the market is rational some of the time is different from the proposition that the market is always rational.

The proposition that the market is rational some of the time is different from the proposition that the market is always rational.

Even a broken clock tells the correct time twice a day

Negative Empericism. We dont have to prove that markets are efficient We can prove that if they were efficient then some things should not happen. For example the following should not exist: 1.Cash Bargains 2.Debt-Capacity bargains 3.Over and under reactions 4.Closed-end fund puzzle

Insanity out of EMT: Since price = value there are no wealth effects in IPOs and stock buybacks

Example # 5: The Human Rationality Assumption in Economics

Almost all of traditional economics is based on the notion of the rational man assumption.

Choose between: 85% chance of winning $100 (the gamble) or sure gain of $85 (the sure thing)

Choose between: 85% chance of losing $100 (the gamble) or sure loss of $85 (the sure thing)

I am 90% sure that empty 747s weight is between ____ and ____ tons.

Ans: 177 tons

I am 90% sure that the moons diameter is between ____ and ____ kilometers.

Ans: 3,476 kms

Converting Confidence Level into a money bet

Rs 1,000 saved on a Rs 10 lac car is worth MORE than the Rs 1,000 saved on a Rs 10,000 lamp. Really it is! After all the Rs 1,000 saving when compared to Rs 10 lacs looks SO MUCH SMALLER than the Rs 1,000 saving on a Rs 10,000 lamp.

Example # 6: The Bell Curve Assumption

In a world described by the bell curve, most values are clustered around the middle. The average value is also the most common value. Outliers contribute very little statistically. If 100 random people gather in a room and the world's tallest man walks in, the average height doesn't change much. But if Bill Gates walks in, the average net worth rises dramatically.

Height follows the bell curve in its distribution. Wealth does not. It follows a L-shaped distribution called power law where most values are below average and a few far above. In the realm of the power law, rare and extreme events dominate the action. If you observe low-probability-high-impact events, then the bell curve is the wrong distribution to capture that. In the power law world, one single observation can impact the aggregate. Its RARE but its HIGHLY CONSEQUENTIAL. Things in such a world are UNPREDICTABLE. RANDOMNESS DOMINATES. Someone who happened to be in the right place at the right time, WINS e.g. surng. The world is changing and the frequency of power law situations is changing. Our strategies for managing risk including MPT and Black-Scholes for option pricing, are likely to fail at the worst possible moments. - e.g. LTCM, and recent debt market turmoil. The power law world is SCALABLE. Moreover it has WINNER TAKES ALL attributes.

Nassim Taleb

Theres a place he calls Mediocristan. This was where early humans lived. Most events happened within a narrow range of probabilities within the bell-curve distribution still taught to statistics students. But we dont live there any more. We live in Extremistan, where black swans proliferate, winners tend to take all and the rest get nothing.

theres Bill Gates, Steve Jobs and a lot of software writers living in a garage.

theres Domingo and a thousand opera singers working in Starbucks.

theres JK Rowling, and a million starving fiction writers

Winner Takes All

7 SD is once every 3 billion years! Models based on the bell curve distribution, massively underestimate the both the probability as well as the impact of of outlier events.

Would you like to jump out of this plane with this parachute which opens 99% of the time?

Modern Risk Management Practices Advocate that you should jump

Modern risk management practices (e.g. VAR) assume that we live in a world best described by a bell curve where outliers are extremely rare, and that resulted in management practices that were far more risky than was previously imagined

What you really want a course on investing is how to value a business. Thats what the game is about...

And if you look at whats being taught, I think you see very little of how to value a business.

And the rest of it is playing around with numbers or Greek symbols of something of that sort... But that doesnt do you any good. In the end, what you have to decide is whether youre going to value a business at $400 million, $600 million or $800 million - and then compare that with the price. Thats what investing is. And I dont know any other kind of investing to do. And that just isnt taught. And the reason why it isnt taught is because there arent teachers around who know how to teach it... They dont know themselves. And since they dont, they teach that nobody knows anything - which is the efficient market theory. . .

Some of the worst business decisions Ive seen came with detailed analysis. The higher math was false precision. They do that in business schools, because theyve got to do something. - 2009 AGM

Thought # 1: A lot what youve been taught is wrong (in my view)

Example # 1: The Notion of Risk in Academic Corporate Finance

Example # 2: The Relationship between Risk and Return in Academic Corporate Finance

Example # 3: The Capital Asset Pricing Model (CAPM)

Example # 4: Markets are Efcient

Example # 5: The Human Rationality Assumption in Economics

Example # 6: The Bell Curve Assumption

Thought # 2: While people are irrational in very predictable ways, you can work towards becoming rational

Thats what youll learn in Behavioral finance module

Thought # 3: You can make money off people who are irrational

Thats what youll learn in Business Valuation module

Thank You